Volatile Market Conditions Create Unique Challenges To Managing Price Risk

Opportune LLP

Find out why volatile market conditions are creating unique challenges for mineral and royalty owners to manage price risk.

I had the pleasure of moderating one of the panels at the World Oilman’s Minerals and Royalty Conference (MARC) held in Houston. The title of our session was “Managing Risk”, which of course is an extremely broad topic. We focused our discussion specifically on commodity price risk, and we got some great insights from two industry veterans in energy trading: Greg Broussard, Managing Director and Global Head of Financial Trading for Cargill; and John Saucer, Head of Crude Oil Markets for Mobius Risk Group.

The launching point for our conversation was three observations about the state of energy derivatives markets, and from there we dove into the implications and hedging considerations for mineral owners.

READ MORE: Is Oil Price Volatility Increasing In The Long Run?

Price Volatility Has Increased — I touched on this in a previous editionof our newsletter, but there are different ways of quantifying volatility. In our MARC panel, we looked at the 60-day crude oil price volatility and observed that it has increased from 25% in November 2021 to 65% currently; in early March, it hit 100%. This higher volatility has generated wider bid/ask spreads for swaps and higher premiums for put options.

Acute Levels Of Backwardation — This relates primarily to the crude oil markets, and there are a couple of different ways to quantify this. A quick way is to take a look at the annual average forward prices on page 2 of our newsletter and see how quickly the average forward prices drop. This creates a challenge for hedgers as they try to decide whether to lock in those prices to reduce uncertainty or assume that the conditions that are generating high prices now will persist into future periods and cause spot prices to come in higher than the forward curve suggests.

Increased Levels Of Credit Exposure — Following the 2018 downturn in the U.S. upstream unconventional business, investors placed a greater emphasis on generating and protecting positive cash flow than they had during the prior decade. This led operators to hedge higher levels of their expected production for longer tenors. The recent run-up in prices, however, has left their hedge counterparties with particularly large credit exposures, particularly for swaps, and this is causing higher credit charges (often hidden in bid-ask spreads), higher collateral requirements, and reduced appetite for similar positions.

READ MORE: Top 5 Ways To Be Prepared For A Risk Management Implementation

Some of the responses to these market conditions we discussed include increased use of options in the longer-dated hedge periods, “stair-stepped” hedge ratios to leave more room for price upside, and lower overall PDP hedge ratios to maintain price upside without purchasing options.

The discussion re-emphasized to me how important it is for hedgers to have an advisor that can help them develop strategies and conduct price discovery to execute the approach that makes the most sense for them at the best price.

Previously published in the Ralph E. Davis Associates (RED) Weekly E&P Update Newsletter, April 26, 2022 edition.

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Opportune LLP


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